By Satyajit Das, a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives:

One year ago, AIG was brought to the brink of bankruptcy as a result its exposure under credit default swaps (“CDS”) (a form of credit insurance). Asset backed securities and Collateralised Debt Obligations (“CDOs”), which lived up to its cheery nickname Chernobyl Death Obligation, brought the financial system to the edge of collapse.

Volatile equity and currency markets caused problems with exotic option “accumulators” (known to traders as “I-will-kill-you-later”). Numerous investors and corporations are bunkered down with their lawyers hoping to litigate their way out of significant losses on “hedges” pleading familiar defenses – “I did not understand the risks” or “I was misled about the risks by the bank”.

If you assumed that these events meant that wild beast of derivatives would be tamed, then you would be wrong. History tells us that there will be cosmetic changes to the functioning of the market but business as usual will resume in the not too distant future. Problems with derivative problems of portfolio insurance in 1987 and Long Term Capital Management (“LTCM”) in 1998 did not lead to fundamental changes in the operation of derivatives markets.

“Holy water”, “hosanna’s” or other utterances (based on particular religious convictions) will be sprinkled or said in the form of initiatives to improve disclosure, increase capital and a new centralised counterparty (“CCP”) to reduce the risk of a major dealer failing. Fundamental issues – the use for derivative for speculation, mis-selling of instruments to less sophisticated market participants, complexity, valuation problems – will not be substantively addressed.

The industry and its key lobby group (ISDA – International Swaps & Derivatives Association) are well practiced in the art of regulatory skullduggery.

Derivatives, it will be argued, are soooo complicated that only derivative traders themselves can properly “regulate” them. If this fails then there will be more subtle rhetorical thrusts.

The new CCP is only for “standardised” derivatives. Already, there are impassioned semantic debates about what is meant by “standard derivatives” and whether they can actually be cleared through the CCP.

On 17 September 2009, Robert Pickel, ISDA’s CEO, argued before the U.S. House Agriculture Committee: “Not all standardized contracts can be cleared.” He argued that that even if they have standardized economic terms many derivatives contracts will be “difficult if not impossible to clear” because the CCP depends on such factors as liquidity, trading volume and daily pricing. This would, Pickel argued, make “it difficult for a clearinghouse to calculate collateral requirements consistent with prudent risk management.”

Dan Budofsky, a partner at Davis Polk & Wardwell LLP, who testified on behalf of the Securities Industry and Financial Markets Association, agreed that “it may be more appropriate for products that trade less frequently to trade over-the-counter.”

The industry will argue for self-regulation, which bears the same relationship to regulation that self importance does to importance.

The reasons for policy inaction are complex. As undoubtedly numerous professors from well-known universities will testify, derivatives do perform important risk transfer functions within modern capital markets – the Dr.Jekyll side of derivatives. ISDA’s Pickel laid out this argument with eloquent panache arguing against standardisation and the CCP as it “would undercut their very purpose: the ability to tailor custom risk-management solutions to meet the needs of end-users.”

Derivatives by their inherent nature are also have a Mr. Hyde side. The ability to use derivatives to speculate, create off-balance sheet positions, increase leverage, arbitrage regulatory and tax rules and manufacture exotic risk cocktails will continue to be a major factor in derivative activity.

The reality is that hedging and risk management is secondary to the other uses. For companies, the ability to use derivative trading to supplement traditional earnings, which are under increased pressure, is irresistible. For institutional and retail investors, the use of derivatives to improve returns through leverage and access to different risks is now a vital part of the investment process.

For banks, the Dr. Jekyll of derivative trading is the revenues that can be generated. The Dr. Hyde is the risks in derivative trading that are generally deferred into a Panglossian future “neverland” using complex models, based on arcane mathematics and confidence that only ignorance can support.

The complexity of modern derivatives has little to do with risk transfer and everything to do with profits. As new products are immediately copied by competitors, traders must “innovate” to maintain revenue by increasing volumes or creating new structures. Complexity delays competition, prevents clients from unbundling products and generally reduces transparency. Frequently, the models used to price, hedge and determine the profitability also manage to confuse managers and controllers within banks themselves allowing traders to book large fictitious “profits” that their bonuses are based on.

The sheer importance and size of derivative profits means that it will continue to attract the best and the brightest who will continue to play these time honoured games.

Warren Buffet once described bankers in the following terms: “Wall Street never voluntarily abandons a highly profitable field. Years ago… a fellow down on Wall Street…was talking about the evils of drugs…he ranted on for 15 or 20 minutes to a small crowd…then…he said: “Do you have any questions?” One bright investment banking type said to him: “yeah, who makes the needles?

Derivatives and debt are the needles of finance and bankers will continue to supply them to all the Dr. Jekyll’s and Mr. Hyde’s alike for the foreseeable future as long as there is money to be made in the trade.

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34 comments

The ability to use derivatives to speculate, create off-balance sheet positions, increase leverage, TAKE DOWN THE COMPETITION WITHOUT THEM SEEING IT COMING, arbitrage regulatory and tax rules and manufacture exotic risk cocktails will continue to be a major factor in derivative activity.

I have nothing against speculators who speculate with their own money. It is only when they let the taxpayer insure their risk by acting within a big bank, that it becomes bad. So either another Glass-Steagal act is needed, or those derivatives should be plainly outlawed.

The nice thing about OTC derivatives is that they don’t have a market quote.
So you cannot mark to market — you mark to model, your own model. You yourself can then determine the “profit” by finetuning the model parameters.
When the flow of events has clarified the picture at some future time you have already pocketed your bonus.

Downsouth if you can’t understand the simple English of Das how can you possibly hope to understand the philosophers you quote. If you had even bothered to try and interpret what Das is saying, how can you come to any conclusion other than that Das is again warning against the unfettered use of derivatives as a “risk management” tool. Das has been warning for years now what was to come. He has been a “voice in the wilderness”. In the future stick to Dr Suess: “I have heard there are troubles of more than one kind. Some come from ahead and some come from behind. But I’ve bought a big bat. I’m all ready you see. Now my troubles are going to have troubles with me!”.

Take this little jewel of wisdom, for instance: “The sheer importance and size of derivative profits means that it will continue to attract the best and the brightest who will continue to play these time honoured games.”

No, Mr. Das, it will not continue to attract “the best and the brightest,” it will continue to attract the greediest and the most immoral.

We use survey data to study American households‘ propensity to default when the value of their mortgage exceeds the value of their house even if they can afford to pay their mortgage (strategic default)… We also find that no household would default if the equity shortfall is less than 10% of the value of the house. Yet, 17% of households would default, even if they can afford to pay their mortgage, when the equity shortfall reaches 50% of the value of their house.

Zingale of course gets the emphasis all wrong. For what’s truly amazing about this is not the 17% that would default, but the 83% of Americans who, if caught in a situation where, let’s say they owed $400,000 on a home that is worth less than $200,000, would continue to pay their mortgage. In other words, 83% would do what’s right instead of what’s profitable.

That’s right, Mr. Das, a majority of Americans still have a little class, a little pride and some morals.

Unfortunately, practically 100% of America’s financial and political leaders fall into the 17% and not the 83%. And the 17% have an army of highly accomplished sophists like Mr. Das to press their case for them.

There is of course nothing new about any of this. Hannah Arendt provides some historical perspective here:

The Reign of Terror, we should remember, followed upon the period when all political developments had fallen under the influence of Louis XVI’s ill-fated cabals and intrigues. The violence of terror, at least to a certain extent, was the reaction to a series of broken oaths and unkept promises that were the perfect political equivalent of the customary intrigues of Court society… Promises and oaths were nothing but a rather awkwardly construed frontage with which to cover up, and win time for, an even more inept intrigue contrived towards the breaking of all promises and all oaths… The widespread opinion that the most successful modes of political action are intrigue, falsehood, and machination, if they are not outright violence, goes back to these experiences… Whenever (genteel) society was permitted to invade, to overgrow, and eventually to absorb the political realm, it imposed its own mores and ‘moral’ standards, the intrigues and perfidies of high society, to which the lower strata responded by violence and brutality.
–Hannah Arendt, On Revolution

Me think you are misreading Das big time. He doesn’t argue FOR the game of derivatives to continue, far from it. He merely says that, short of a complete reversal in our way to regulate, and as long as there is big money to be made in it, there will be bright people who will prefer to do that than trying to discover the next big thing.

BTW, the best and the brightest does not mean the more moral and ethical people around. I know that this is Das thinking, because a cursory review of his interviews over a period of several years* make this point perfectly clear.

Like I point out in my comment down thread, this trick is as old as the hills, and Niebuhr frames it perfectly. The public gets sandwiched in between the defeatism of the Dases of the world (The rape is inevitable, so just as well lay back and enjoy it.) and the Pollyannasishness of the Obamas of the world (All we have to do is just talk nice to those rapists and they’ll change their evil ways–see Jesse’s post in today’s Links http://jessescrossroadscafe.blogspot.com/2009/09/obama-to-ask-g20-to-change-world.html ), with the end result being that nothing substantive ever gets done.

Deep breath Down South… when you don’t know who your friends from your foes there are problems. It’s a shame we are becoming incapable of a decent argument (and by argument I mean discussion of valid points) without aggression….

I am hoping you mean teacher / educator when you use the word sophists but I fear not.

I would just add that there is nothing new or innovative about Das’ rhetorical strategy. It is the same as has been used for centuries by religious scholars, serving as apologists for those seeking to uphold an unjust order. Reinhold Niebuhr explains as follows:

Nevertheless the tendency of religion to obscure the shades and shadows of moral life, by painting only the contrast between the while radiance of divine holiness and the darkness of the world, remains a permanent characteristic of the religious life.

This tendency has more than one dubious effect. It certainly tends very readily to a moral, social and political indifferentism. The individual, and more particularly society, are regarded as too involved in the sins of the earth to be capable of salvation in any moral sense… Thus Augustine concludes that the city of this world is “compact of injustice,” that its ruler is the devil, that it was built by Cain and that its peace is secured by strife. That is a very realistic interpretation of the realities of social life. It would stand in wholesome contrast to the sentimentalities and superficial analyses, current in modern religion, were it not marred by a note of defeatism. That note creeps easily into all rigorous religion, with its drift toward dualism. The injustices of society are placed into such sharp contrast with the absolute moral idea, conceived by the individual conscience, that the religiously sensitized soul is tempted to despair of society.

Thus Das posits the following: “Derivatives and debt are the needles of finance and bankers will continue to supply them to all the Dr. Jekyll’s and Mr. Hyde’s alike for the foreseeable future as long as there is money to be made in the trade.” The subtext here is of course that this is just the way the world is and that nothing can possibly be done about it. It’s the Clayton Williams worldview:

Clayton Williams stirred controversy during his 1990 campaign for governor of Texas with a botched attempt at humor in which he compared rape to weather. Within earshot of a reporter, Williams said: “As long as it’s inevitable, you might as well lie back and enjoy it.” Yesterday, John McCain cancelled his attendance at a fundraiser with Clayton Williams, who gave the following advice to rape victims: “As long as it’s inevitable, you might as well lie back and enjoy it.”http://crooksandliars.com/2008/06/14/mccain-fundraiser-rape-is-like-the-weather#comment-641656

Dear DownSouth, could please stop making stinking pseudo-intellectual references when totally going off the track – you never bothered to even read Das’s arguments nor I suspect are You capable of understanding them. Unlike You, Das offers real arguments against greed – the stupidity of you just sends people either to despair or to prefer greed as more simple and more of an image of virtue than the pseudo-humanitarian bull that you give out.

@DownSouth: I too believe you misread Das. I read his post as opposition to derivatives trading not a rationale for its continuance.

My only criticism is in the sentence: “For institutional and retail investors, the use of derivatives to improve returns through leverage and access to different risks is now a vital part of the investment process.”

The word “vital” is incorrect. Replace it with significant, substantial, important (occasionally irrelevant, at least to some of us) and the sentence is better writ.

All the complexity and opaqueness of contemporary finance has produced little of actual ecnomic value. Just losses. It has diverted our brightest from productive enterprise into non-productive paper (pixel?) shuffling that provides select individuals with large salaries and even larger bonuses by offsetting the risk on the national taxpayer.

You say that you “read his post as opposition to derivatives trading not a rationale for its continuance.”

If that is true, then why does Das make statements like this?

History tells us that there will be cosmetic changes to the functioning of the market but business as usual will resume in the not too distant future. Problems with derivative problems of portfolio insurance in 1987 and Long Term Capital Management (”LTCM”) in 1998 did not lead to fundamental changes in the operation of derivatives markets.

I suppose that if one believes that history began 40 or 50 years ago, one might buy into Das’ defeatist theory. But if we take a look at a longer sweep of American history, the falsity of his assertion immediately becomes apparent.

Kevin Phillips in Wealth and Democracy does a superb job of recounting that long sweep of American history. He begins in the days of the Revolution and brings us all the way up to the turn of the 21st century. And what he points out is that historical eras like those circa 1970-2009 are not at all unique to the United States, nor is the philosophy that underpins them:

[S]windless are a response to the greedy appetite for wealth stimulated by the boom.

Less obtrusive but at least as important has been the corollary corruption of thinking and writing—the distortions of ideas and value systems to favor wealth and the biases of “economic man.” In this sense, too, the eighties and nineties echoed the Gilded Age and the 1920s.

But, and this is key to debunking Das, following in the wake of both the Gilded Age and the Roaring Twenties were reform movements that rolled back not only the worst abuses of banking and finance, but also the “money-culture ethics” used to justify them.

And these two were not the only reform movements that arose against banking and finance in American history. Phillips details other reform movements, which originated from both sides of the aisle. There were the Democrats: “The eras begun by Jefferson in 1800, Jackson in 1828, and Franklin D. Roosevelt in 1932 all involved successful confrontations with the bankers and ‘money-changers.’ “ And there were the Republicans:

Skeptics will say that the Republican presidents before the booms were much the same as the ones who came later. This is simply not true. The early presidents in the three Republican cycles—Lincoln and Andrew Johnson from 1896 to 1868, William McKinley and Theodore Roosevelt from 1896 to 1908, and Richard Nixon from 1968 to 1974—were much more progressive if not populist in their economics, for which there is abundant documentation.

I read Das in one of two ways. Either he is an apologist for the finance industry and deliberately gives us a bowdlerized version of history that jives nicely with his sophistry. Or he is just totally ignorant of American history. Take your choice.

DS – I have been following Das for 3 years now. Yes, you misunderstand him. An apologist he is not, a defeatist he is not – and most of all – he is well read in US history.

That said, Das, to me, represents one who has seen this coming for such a long time, has seen the inner workings of our financial system, personally knows all the types involved and their influential powers and has arrived at a conclusion:

When one fully appreciates the frailty of humanity’s predicament, one can do nothing else but laugh. (I think I’m paraphrasing someone here)

Why? He has already gone through all the steps of grief. He has reached a Nirvana of sorts. He tries to explain, for those that want to gain that knowledge, yet accepts that the system will just eventually self-correct. He has already grieved. Nothing to do but watch now, for entertainment purposes.

Das has it exactly right. Opaqueness and complexity are vital to the illusions which maintain the ‘investment process’. No doubt they are critical in the manufacture of ‘earnings improvements’ which even now are being levered by nonstop CNBC idiocy to lure retail buyers back into the stock market, while not incidentally permitting hedge fund operators and the holders of repriced executive stock options to escape with the latest round of gains. Those who read Das as ‘favoring’ derivatives might gain by reading the full text again. I don’t think Niebur is terribly helpful in all this, but I don’t blame him either.

I can accept that you do not believe that Das does not have it right, and that he is propagating an excuse for that which is the continuation of financial fraud.

While philosophically interesting, Reinhold Niebuhr, Hannah Arendt, etal, will not solve the problem that is inherent in the derivatives miasma we enjoy today. Dishing Das is terribly off the point. What is on point is the fact that ill-conceived incentives and unenforced constraints point the denizens of the trading desks of the world toward what are, effectively, unearned profits. Now give that some thought.

Now, if you would read Das and see that he is saying that this the world we have; and now what do we do about it? Grasp that, then you will have made some progress in the improvement of your critical reading and reasoning skills.

I suggest that you familiarize yourself with the Federalist Papers. In those wrtings there is precious little discourse that is reliant on theology and a great deal of discussion about the recognition that incentives and constraints are the key to a political economy that offers the greatest degree of liberty to all.

Above all, please be contributory rather than denegrating that which you obviously do not understand!

You say, “I suggest that you familiarize yourself with the Federalist Papers. In those wrtings there is precious little discourse that is reliant on theology and a great deal of discussion about the recognition that incentives and constraints are the key to a political economy that offers the greatest degree of liberty to all.”

If you choose to adopt the Federalist Papers as your Holy Writ, then I suppose that’s your prerogative. However, to admonish me to do likewise smacks of high-handedness.

To be honest, I have some severe problems with the Federalist Papers, such as this one:

The Federalist Papers (specifically Federalist No. 84) are notable for their opposition to what later became the United States Bill of Rights. The idea of adding a bill of rights to the constitution was originally controversial because the constitution, as written, did not specifically enumerate or protect the rights of the people, rather it listed the powers of the government and left all that remained to the states and the people. Alexander Hamilton, the author of Federalist No. 84, feared that such an enumeration, once written down explicitly, would later be interpreted as a list of the only rights that people had.http://en.wikipedia.org/wiki/Federalist_Papers

Hamilton was certainly no friend to the rank and file American. As Kevin Phillips points out in Wealth and Democracy, Hamilton became notorious for his “use of government banking and debt to reward a wealthy elite.”

Hamilton’s influence on the nascent republic was to be progressively rolled back over time. The Bill of Rights was to become the first ten amendments to the United States Constitution. They were introduced by James Madison to the First United States Congress in 1789 as a series of articles, and came into effect on December 15, 1791, when they had been ratified by three-fourths of the States. Thomas Jefferson was a proponent of the Bill of Rights, including the First Amendment which reads:

Congress shall make no law respecting an establishment of religion, or prohibiting the free exercise thereof; or abridging the freedom of speech, or of the press; or the right of the people peaceably to assemble, and to petition the Government for a redress of grievances.http://en.wikipedia.org/wiki/United_States_Bill_of_Rights

As Phillips goes on to explain:

Wealth and aristocracy remained a target through 1800 as the rich-poor gap widened in the major cities. The share of assets held by the top 10 percent in New York City climbed from 54 percent in 1789 to 61 percent by 1795, while much the same thing occurred in Philadelphia. New York and Pennsylvania were also the hotbeds of conspicuous speculation, and Pennsylvania farmers were the angriest over Federalist taxes. When the elections of 1800 gave Jefferson twenty of the two states’ combined twenty-seven electoral votes, the Virginian beat John Adams, and no Federalist ever again held the presidency.

I can see that you have considerable talent towards finding quotes that satisfy your preconceptions. I consider the Federalists Papers to be holy writ. They are an important part of a larger dialogue that was in progress at the founding of our nation and it continues to this day.

I am moderately indifferent as to whether you would adopt the Federalist Papers as your guide, taken in their entirety, as a reasonable guide to the formation of a political economy that offers the greatest degree of liberty to the greatest number of people within the society. What does trouble me is that your contributioons here tend to be without focus and heavily reliant on a handful of philosphers whose points of view, in varying degree, tend to be socialistic.

Your response to my criticism has a beginning, a bit of a middle; BUT no conclusion! There’s the rub, lots of quotation to present a facade of erudition with no substance to provide a rational argument. You strike me as a dilatante. Tell us, Down South, what do you believe. What would you do about derivatives trading?

♦ “Tell us, Down South, what do you believe. What would you do about derivatives trading?”

I’d ban them. The only derivatives I’d allow would be those for producers and users, for instance an oil producer and a refiner, a refiner and a trucking company, or a farmer and a food processor. And delivery of the physical commodity or product would be mandatory. Other than that, they would cease to exist.

♦”What does trouble me is that your contributioons here tend to be without focus and heavily reliant on a handful of philosphers whose points of view, in varying degree, tend to be socialistic.”

I think perhaps Hannah Arendt gave the best retort to that: “Now just what people imagine by socialism I do not know.”

♦ “I can see that you have considerable talent towards finding quotes that satisfy your preconceptions.”

I find it strange that you would find fault with the use of quotes and citation. It’s a practice that emerged in the late 15th century and has been in use ever since. As Jacques Barzun explains in From Dawn to Decadence:

As for the Humanist method, it is the one still in universal use. Its conventions are commonplace everywhere: in government, business, the weekly magazines, and even in schoolwork–who has escaped “research”? who dares ignore exact quotations and date, consulting previous work, citing sources, listing bibliography, and sporting that badge of candor, the footnote?

What would you have us do, go back to the Dark Ages? Do you prefer the style of debate where people don’t have to document what they say or provide the source of their ideas, as was the case before the advent of the printing press?

♦ “I consider the Federalists Papers to be holy writ. They are an important part of a larger dialogue that was in progress at the founding of our nation and it continues to this day.”

They were indeed an important part of a larger dialogue, but only a part. But is it not important to acknowledge where the Federalists were coming from and what their agenda was? Again, quoting Kevin Phillips:

The debate over the compatibility of wealth and democracy is as old as the republic. From the start, concern that the egalitarian-seeming United States of the late eighteenth and early nineteenth centuries might develop wealth concentrations to match Europe’s was a worry for many but also the guarded hope of an important few.

Alexander Hamilton, who favored both a financial class and an aristocracy, would have cherished the possibility of such an elite. John Adams, who thought aristocracies inevitable, would not have been surprised. Thomas Jefferson brooded that such a danger could flow all too easily from urban growth, finance, and commerce. Richard Price, the British reformer friendly to the American Revolution, warned the new nation against foreign banks and finance and Alexis de Tocqueville, in 1837, hedged his praise for democracy in America with concern that the new industrial elite, “one of the harshest that ever existed,” would bring about the “permanent inequality of conditions and aristocracy.”

From the examples given by Phillips, I’d put Das in the same league with John Adams, who believed aristocracies to be inevitable. But like I pointed out earlier, the American people rejected Adams in 1800, along with his Federalist philosophy.

It’s well known by now that we live in a time when the financial sector, through the insulting implication of “these things are too difficult for government to understand” have proven that they are too difficult for them to understand. Time and again, they wave the flag of free markets and Congress backs down (once they receive a fat campaign check).

I would tend to agree with DeepSouth with his contention that only those with a dog in the fight are allowed to bet. But that’s restraint of trade and as Das points out, lots of dollars rely on the increased risk.

It’s truly a shame that most posters have failed to read deeply into “For companies, the ability to use derivative trading to supplement traditional earnings, which are under increased pressure, is irresistible.” Why are traditional earnings under pressure? Have companies lost their innovative edge? Do American companies no longer have the ability to create our way into profitability? But I digress.

What bothers me is the Fed and Treasury “put”, once your company gets “too big to fail”, completely obliterates any type of moral hazard. If your company or investor wants to increase risk and interest rate, then by all means, have at it. I just wish the Fed & Treasury had the backbone to attempt fiscal suicide by letting them fail; AIG, Goldman, any number of investment “banks”. Bankrupt is exactly the lesson for poorly investing other people’s money and losing it (I personally long for the return of the stocks or the iron maiden). Read the prospectus, place your bets, spin the wheel and if you lose don’t come crying to us.

I hope you are wrong about the fate of derivatives regulation, but fear you are right. In the meantime, this line is pure brilliance: “The industry will argue for self-regulation, which bears the same relationship to regulation that self importance does to importance.” I intend to quote it at every available opportunity.